Should RBI target inflation?

There are respected names arguing both for and against this recommendation of the Urjit Patel committee

Whether the Reserve Bank of India (RBI) should target a particular level of inflation in its monetary policy or not has many disagreeing, including some prominent names.

Doing so (i.e. targeting inflation) was one of the key recommendations of the Urjit Patel committee report. It also suggested adopting Consumer Price Index-based inflation as the anchor measure, with a monetary policy committee to be given a mandate to maintain the level around a specific range. It was to be accountable for achieving this.

“I don’t personally believe in targeting inflation, particularly in developing countries like India, where 60 per cent of the Consumer Price Index (CPI), which matters more to the common person, is from food prices,” former RBI governor Bimal Jalan had said at a discussion on January 14, a few days before the Patel report was issued for public reading. That discussion was moderated by the present governor's predecessor, D Subbarao. And, Y V Reddy, another former governor, was the other participant.

Sajjid Chinoy, India Economist, JPMorgan, and a member of the Patel panel, said empirical evidence supported the inflation target theory.

“Other emerging markets also have large weights of food in their CPI and are also subject to weather and other supply shocks. This hasn’t stopped them from pursuing flexible inflation targeting for two decades now and successfully lowering inflation expectations,” he said.

Disagreement came recently from noted economist T N Srinivasan. “I have serious reservations about its (inflation targeting’s) relevance and applicability in the domestic context,” said Srinivasan, also the Samuel C Park Jr Professor Emeritus at Yale.

The Patel committee members say higher food and fuel prices will give rise to inflation expectations. “These, in turn, give rise to higher wage settlements and contribute to a wage-price spiral,” said Rupa Rege Nitsure, a panel member.

She says as 65 per cent of the population, which is growing at 1.5 per cent annually, is below the age of 35 years (and half are below 25), this will continue to create strong demand pressures for food articles and energy products. RBI cannot afford to ignore this in its inflation management strategies.

Also, “a need was felt to move away from the multiple indicator approach to a price stability-oriented monetary policy framework, as inflation in India has remained consistently elevated (close to 10 per cent) during the post-global crisis phase and this is among the highest within the G-20 countries,” said Nitsure.

Chinoy argues the central bank will continue to have enough flexibility to pursue other objectives. “I believe when CPI inflation is running at 10 per cent and inflation expectations are so entrenched, there is little trade-off between inflation and growth. The idea is not to be rigid but to pursue flexible inflation targeting, wherein everyone is aware of the central bank’s target in the medium term – which should help business planning, wage negotiations and anchor household expectations — but leave enough flexibility for RBI to pursue other objectives in the short run,” he said.

Another issue flagged by many, including former governor Y V Reddy, is that if RBI be alone responsible for inflation targeting, this would mean the government can wash its hands off. “Can we sell it to the people in India that the government is not responsible for inflation and the Reserve Bank is, especially when inflation is high? ...Elections are won or lost on inflation, more than anything else. Government cannot wash its hands off inflation in India,” Reddy had said in the seminar earlier referred to.

Since, the government also has a role in keeping inflation low, concerns have been raised that if RBI fails to bring down inflation, it will erode its credibility. To which Nitsure says, “The committee report has clearly stated there is a requirement of a commitment from the government towards elimination of administered setting of prices, etc...It has also proposed that the government commit to bring down its fiscal deficit to GDP ratio to three per cent by 2016-17 as a precondition.